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Don't Be Fooled by These 4% Dividend Yields

All three of these retailers have healthy dividends on the surface, but there's trouble beneath.

Traditionally, large and well-established companies that pay out dividends are some of the safest investments on the stock market. But the world is changing -- and previously untouchable industries are being disrupted overnight. Since the Great Recession, no industry has been upended so much as retail.

In the past, the breadth of a company's physical locations helped offer a moat. But with the advent of e-commerce and the absolute dominance of Amazon.com, those very same brick-and-mortar locations are now more of a liability for retailers.

If your looking for popular companies with big dividends today, you might get excited to see that Macy's (NYSE:M), Gap (NYSE:GPS) and Kohl's (NYSE:KSS) are all sporting yields over 4%. But don't be fooled: all three of these companies are experiencing significant problems that could soon affect the ability to pay its dividends.

Comps are plummeting

In retail, there's no metric quite so important as a comparable-store sales -- otherwise known as "comps." Any company can grow sales simply by opening up new locations. But that's an expensive endeavor, and doesn't really offer a very good glimpse at how popular a store really is with consumers.

If a clothing company can incrementally increase its comps -- at the very least keeping up with inflation -- investors know that business is relatively stable. But though all three of these companies experienced some growth immediately following the Great Recession, things aren't looking good now.

Kohl's had long been the underperformer of these three, but there was hope in the wake of last year's positive comps that the company might be turning a corner. While online sales have been growing, and the company has actually been opening new locations, the last quarter was not a good one. Heavy discounting to reduce inventory led to results that came in well below expectations.

Macy's fared even worse. Management isn't sugar-coating the 6.1% drop in comps. Said CEO Terry Lundgren in the last conference call: "We are seeing continued weakness in consumer spending levels... Headwinds also are coming from a second consecutive year of double-digit spending reductions by international visitors in major tourist markets where Macy's and Bloomingdale's are key destinations."

And Gap hasn't had anything to drag about, with comps down at all three of the company's chains: The Gap, Old Navy, and Banana Republic. Management claims that it can turn the business around -- by reinvigorating its marketing campaigns, and continuing its push in direct-to-consumer lines of business. So far, however, there's little to show for these efforts.

How long until these dividends fall?

The best way to measure the strength of a company's dividend is to evaluate its free cash flow (FCF). Unlike earnings -- which can be massaged through accounting gimmicks -- FCF offers a more accurate picture for how much money a company was able to put in its pocket during the course of the year.

At the end of the day, it is from FCF that dividends are paid. As you can see, none of these dividends are in imminent danger. In fact, on the surface, they appear pretty healthy -- none of them is using more than half of FCF to pay dividends!

But there's a dangerous trend forming here -- and investors that wait for these ratios to creep above 80% will be too late once that time comes. If same store sales keep, these companies will be in danger. Already, the overall "cash stash" at each has also fallen from previous highs.

Company

Early 2014 Cash on Hand

Current Cash on Hand

Difference

Macy's

$2,300 M

$734 M

(68%)

Gap

$1,500 M

$1,300 M

(13%)

Kohl's

$971 M

$423 M

(56%)

Data source: Yahoo! Finance.

Gap is clearly the strongest of the three in this respect. But the continued poor performance across all three of the company's brands may soon start affecting cash on the balance sheet.

For Macy's and Kohl's, the dramatic drawdown in cash is alarming, especially as it has taken place over little more than two years. If these trends don't turn around -- and soon -- the company may have to start keeping more of its cash on the balance sheet, instead of giving it away through dividends.

The bottom line on all three companies is the same: By traditional metrics, their dividends are safe. But by looking at the trends -- both of the underlying businesses and the payout ratio from FCF -- we see the beginning of a downward spiral that will be unavoidable if things don't turn around soon.

Author

Brian Stoffel has been a Fool since 2008, and a financial journalist for the Motley Fool since 2010. He tends to follow the investment strategies of Fool-founder David Gardner, looking for the most innovative companies driving positive change for the future. Follow @TMFStoffel